Exchange-traded Funds. In association with WEALTH MANAGERW

Transcription

1 Exchange-traded Funds In association with WEALTH MANAGERW W

2 SURELY THE COMPANIES YOU INVEST IN SHOULD HAVE GREAT TRACK RECORDS TOO. Our range of SPDR Dividend Aristocrats ETFs are based on the S&P Dividend Aristocrats indices, which only include companies that have paid stable or increasing dividends over many years. SPDR ETFs aim to deliver income time after time. The reliability of our products is just one of the ways we can help precisely match your investments to your investment strategy. Our Dividend ETFs are part of a collection of income-generating funds, all precision-built to perform. Take a closer look at spdretfsinsights.com. SPDR ETFs is the exchange traded fund ( ETF ) platform of State Street Global Advisors and is comprised of funds that have been authorised by European regulatory authorities as openended UCITS investment companies. ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. The value of the investment can go down as well as up and the return upon the investment will therefore be variable. Changes in exchange rates may have an adverse effect on the value, price or income of an investment. Further, there is no guarantee an ETF will achieve its investment objective. SPDR ETFs may not be available or suitable for you. This advertisement does not constitute investment advice or an offer or solicitation to purchase shares of SPDR ETFs and has been issued by State Street Global Advisors ( SSgA ). SPDR ETFs may be offered and sold only in those jurisdictions where authorised, in compliance with applicable regulations. You should obtain and read a prospectus and Key Investor Information Documents (KIIDs) relating to the SPDR ETFs prior to investing. Further information and the prospectus / KIIDs describing the characteristics, costs and risks of SPDR ETFs are available for residents of countries where SPDR ETFs are authorised for sale, at and from your local SSgA office. SPDR is a registered trademark of Standard & Poor s Financial Services LLC ( S&P ) and has been licensed for use by State Street Corporation. No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by S&P or its affiliates, and S&P and its affiliates make no representation, warranty or condition regarding the advisability of buying, selling or holding units/ shares in such products State Street Corporation All rights reserved. IBGE-0885.

3 Introduction Contents Welcome to Citywire s CPD programme. Endorsed by the CISI, each module counts for one hour of structured CPD when you have successfully completed the online test. Aimed at discretionary wealth managers, this programme will supplement understanding of a range of learning outcomes; in turn, helping with the increasing research commitments and ultimately the demands of managing clients portfolios. As demands on wealth managers time increase, the time for CPD gets squeezed. Each module in this programme has been designed so you can spend 45 minutes reading when convenient and 15 minutes on the online test back at your desk. If you pass with 70% or over, you will receive confirmation of completing the full structured hour. We called upon industry experts to write on their area of expertise so we hope that you find the topics engaging, insightful and valuable. What are ETFs? 6 Types of exchange-traded products 12 How ETPs replicate index returns 19 Trading and pricing 25 The cost question 32 The rise of smart beta 38 This guide covers the ever-growing world of exchange-traded products (ETPs), covering how to analyse and select these vehicles for a portfolio. With a growing focus on passive options for investors, we focus on how these products work, what they can offer in terms of returns and the risks associated. Take the test at 4 5

4 What are ETFs? Exchange-traded products (ETPs) first appeared in the UK in 2000 in the form of passive exchange-traded funds (ETFs) physically holding shares in an index. Although slow to gain traction in the early years, they grew in popularity in 2007 as investors sought liquid funds that ring-fenced assets during the uncertainty of the financial crisis. ETFs are open-ended funds that trade like shares on an exchange, with the main benefits seen as diversification, liquidity and low charges. In their simplest guise, they track an index by buying all the component stocks, providing diversification relative to active stock-picking funds. They are also low in cost, with some ETFs tracking the UK market charging only 0.09% a year. As they are priced throughout the day, with the support of multiple market makers, they are viewed as offering a high level of liquidity. History of ETFs ETFs have their roots in products called index participation shares. The first of this type were the Toronto Index Participation Shares, launched in Canada in 1990, tracking the TSE 35. Soon afterwards, the first ETF in its current guise launched in the US. The Standard & Poor s Depositary Receipts, which are now widely known as SPDRs, were unveiled by State Street Global Advisors in While institutions were the early adopters, retail investors soon accounted for a significant proportion of users and now are estimated to represent half the market. The US ETF now accounts for $1.6 trillion in assets out of a global total of $2.3 trillion, according to BlackRock. The younger European market was born nearly a decade later in The first European ETF was listed in Germany in April 2000, while the inaugural ETF in the UK launched shortly after on the London Stock Exchange. Value of ETFs in Europe Value ( Bn) Source: Deutsche Bank 6 7

5 Who uses ETFs? Pension funds: Pension funds use them in a variety of ways. These include transition management, where an ETF is used as an interim way to get market exposure while an investment manager is replaced with another. Similarly, they can be used for cash equitisation, whereby an ETF is used to invest in the market in the short term while a longer-term strategy is being implemented. ETFs are also used by some funds as a core investment in order to keep investing costs low and stick to an index-based mandate. Fund managers: Like pension funds, these managers can use ETFs as a form of cash equitisation and transition management. They provide exposure to a greater array of asset classes, such as commodities, or specific exposures, such as a segment of the fixed income market. Trading desks: This includes trading for clients, such as hedge funds looking to hedge a position, to trading on the prop desk for the bank s internal benefit. They often form part of a bank s delta one business, where assets and markets are tracked as closely as possible. the year. This landmark regulation banned commission on funds, placing non-commission-paying ETFs on a level playing field with other types of investments. Number of ETFs in Europe 1,600 1,400 1,200 1, Main attraction of ETFs Source: Deutsche Bank Retail: Retail investors in the UK are newer to ETFs and other types of ETPs, but interest is rising. This is largely due to the retail distribution review, which came into force at the start of Low cost Liquid Diversified 8 9

6 What to consider before investing The first step for most investors should include defining the investment objective and time horizon. While a certain ETP might serve as an efficient and low-cost way of implementing an asset allocation call over the long term, the same product might not be as adept at providing highly liquid market access for trading. Investors then have the task of categorising the large range of ETPs to help compare and choose products. These different filters include structure, cost of ownership, the impact of regulatory changes and even subtle performance-enhancing techniques underneath the surface. Once the products have been separated and analysed, there are many ways to select and use them, from portfolio hedging to gaining leveraged exposure. ETFs are regulated The majority of ETFs in Europe are Ucits III-regulated, meaning they must comply with a set of rules. These include that the underlying must be diversified to ensure risk is spread, so an ETF cannot provide concentrated exposure to just gold, for example. One of the cornerstones of Ucits law is the so-called 5/10/40 diversification rule, whereby a maximum of 10% of a fund s net assets may be invested in securities from a single issuer, and that investments of more than 5% with a single issuer may not make up more than 40% of the whole portfolio. However, this rule proved problematic for indices where the relationship between small constituents meant they were considered to represent a single issuer and therefore, in aggregate, exceeded the limits. Now, Ucits funds that track an index can follow the 20% and 35% rule so the index can invest 20% of net assets in shares or debt issued by the same company. This can be raised to 35% when there are exceptional market conditions. ETP regulation is complex, with the products falling under a number of European statutes. In recent years, the major new regulation covering the market has come from the European Securities and Markets Authority (ESMA), which UK s Financial Conduct Authority (FCA) has now incorporated into its own guidelines. These include new rules in securities lending (see page 35) although concerns about synthetic ETPs being labelled complex products, and therefore facing a more stringent regulatory burden, look to have abated. Elsewhere, regulation such as MiFID II is expected to have a positive impact on the ETP space by improving market liquidity while the proposed European Market Infrastructure Regulation (EMIR) could limit the use of derivatives by increasing the required collateral, potentially pushing up costs. Overall, regulatory risk is a clear component of the ETP space and requires ongoing monitoring

7 Types of exchange-traded products There are three main types of ETPs, comprising ETFs, exchange-traded commodities (ETCs) and exchange-traded notes (ETNs). asset classes ETFs can track is wider, from Vietnamese stocks to currency pairs. Traditional index trackers tend to be offered on core, mainstream asset classes. 2. Exchange-traded commodities Exchangetraded products The exchange-traded commodity was first launched in It has provided Umbrella term many small investors with access to commodities for the first time. Despite the similar acronym, there are major differences between ETFs and ETCs that should not be overlooked. ETCs tend to be structured as special purpose vehicles (SPV) that issue debt instruments, rather than funds, which trade on exchange offering Exchange-traded funds (ETF) Tracking underlying index (usually equity and fixed income) Ucits compliant Exchange-traded commodities / currencies (ETC) Tracking underlying commodities/currencies Non-Ucits compliant Exchange-traded notes (ETN) Senior, unsewcured, unsubordinated debt listed on an exchange Non-Ucits compliant exposure to commodities. How ETCs work: Source: Morningstar 1. Exchange-traded funds ETFs resemble traditional open-ended index tracker funds, although there are significant differences. ETFs offer a higher level of liquidity as a vehicle, as they trade intraday whereas index trackers are only priced daily. The buying and selling of ETFs is akin to trading shares, while buying an index tracker is more like purchasing a unit trust. The range of underlying There are two main types of exposure. With physical exposure, the ETC tracks the daily movement of the spot price by holding and valuing the commodity. These products tend to track precious metals or non-perishable commodities that can be stored. The second type provides indirect exposure, using derivatives to track the daily moves of an index typically based on futures contracts. There are other risks investors must take into account with this type of exposure. Derivative-backed ETCs can have various levels of collateralisation, 12 13

8 although many are now fully collateralised. For example, ETFS Wheat is backed by fully funded swaps with counterparties - UBS AG and Merrill Lynch Commodities. The counterparties payment obligations are supported by collateral, which is held in accounts by a separate custodian and marked-tomarket daily. Roll yield tends to be the main factor affecting why an ETC s performance may not match up with the price of a commodity. Roll yield depends on whether the futures are in contango or backwardation. (See explanation below.) The implications of structure should also be considered. As a result of not being funds, ETCs are not Ucits-compliant. However, they are Ucits-eligible, which means they can be held within another Ucits fund. As they fall outside Ucits, these products can provide exposure to single commodities, but investors must beware of the consequent concentration risk. Contango and backwardation: Many ETCs are based on indices comprising futures contracts, and these have expiry dates. Just before they expire, they are rolled, which is where a new longer-dated future is bought, to gain continuous exposure to the commodity. However, the new contracts being bought can be more expensive than the one being sold, meaning the investor would make a loss. This is called contango. So the current price of the commodity is lower than the price of a delivery in the far future. This can often be because the price has to rise over time to cover the expense of storing the commodity in the meantime. Backwardation is the opposite scenario, where the future contracts being bought are cheaper than the current one being sold. This is called backwardation and results in a gain, as the current futures contract can be sold for a higher price than it costs to buy the new futures contract. Oil futures curve in contango US$ / Barrel Front Month Roll P 1 P 2 Month 1 Month 1 Month 1 Month 1 Sources: ETF Securities, Bloomberg (as of 30 July 2010) 14 15

9 Oil futures curve in backwardation 3. Exchange-traded notes P 1 These are similar to ETCs as they are debt securities, but rather than being issued by an SPV, they tend to be launched off the balance sheets of banks. 104 P 2 As they are notes rather than funds and are therefore not subject to Ucits rules, they offer the flexibility of delivering exposure to a wide range of US$ / Barrel Roll asset classes and trading strategies, such as bonds, commodities, emerging markets, currencies, volatility and other more targeted strategies, like leveraged versions. Barclays ipath range is one of the biggest in the US and 101 Europe. ETNs have maturity dates like bonds, and the return of the index is paid on maturity. 100 Front Month Month 1 Month 1 Month 1 Month 1 How ETNs work: Sources: ETF Securities, Bloomberg (as of 30 July 2010) Backwardation is the opposite scenario, where the future contracts being bought are cheaper than the current one being sold. This is called backwardation and results in a gain, as the current futures contract can be sold for a higher price than it costs to buy the new futures contract. An ETN does not own the assets in the index, but buys a derivative that pays out the return of the index minus fees. ETNs tend to be unsecured debt. Although some are collateralised, there are no hard and fast rules on the level of collateral or its quality. One of the main benefits of ETNs is they provide low-cost, liquid access without any tracking error, because the issuer guarantees the investor the exact index return with the exception of any charges. However, there is another set of risks to consider. Investors can have 100% counterparty risk, being exposed to the creditworthiness of the 16 17

10 issuing counterparty or to any third party that is guaranteeing the note s performance. ETNs can lose value if the underwriter of the note has a credit downgrade, even if the fundamentals of the underlying note remain robust. As ETNs are debt securities, they do not have the same level of protection a fund offers namely, independent custody of the assets, a segregation of the liabilities and independent oversight. Furthermore, they may offer less diversified investment exposure, as well as a level of credit risk. 4. Leveraged and inverse ETPs buy-and-hold investors. The regulator urged investors not to mistakenly believe these products can deliver the stated returns over the long term, or periods other than a day. Many of these products now incorporate the word daily in their name to emphasise this, especially following a raft of lawsuits in the US due to investors losing money. In 2011 the UK s regulator the Financial Services Authority warned leveraged ETFs are generally unsuitable for the mainstream retail market. How ETFs replicate index returns These are prolific in the US, but relatively new in Europe and there are few products available. Leveraged ETFs provide magnified exposure to the underlying index, typically by two or three times. However, the daily resetting of the index means by their nature, these ETFs only provide the stated leverage over a day rather than any other time period. Inverse ETPs, which provide short exposure to an asset class, similarly reset on a daily basis. There are, however, a few leveraged and inverse products specifically designed to offer monthly returns. Regulator warning over leveraged and inverse products: The US Securities and Exchange Commission has come out with a range of warnings about the extra risks leveraged and inverse products entail for The way ETFs deliver the return of an index falls into two main types of replication, although there are subsets within these camps and each have their advantages and drawbacks. Physical The first and most prolific type is physical replication, where the fund uses the investors cash to buy the index s constituents. Full replication refers to an ETF investing in all the securities in the same weights as in the index. This tends to be the method for major liquid benchmarks. Optimised or partial replication occurs when an ETF only holds a sample of the index. This method applies to broad indices or those tracking less liquid securities, such as an emerging market benchmark, where buying all the components would be inefficient 18 19

11 and expensive. Generally, this technique also means lower transaction costs because fewer, more liquid securities are traded. Synthetic/swap-based The other category is synthetic or swap-based replication. Rather than the fund holding the index securities, it gains the performance of the index through a swap with a counterparty bank. Different swap structures There are two main kinds of swap arrangement: funded and unfunded. Unfunded: In the unfunded structure, the first type employed in Europe, the ETF uses investors cash to buy a basket of securities from a swap counterparty. The counterparty bank commits to delivering the performance of the index in return for the performance of the securities bought by the fund. The assets tend not to correlate with the actual index. However, this substitute basket has to comply with Ucits rules on asset type and liquidity and to an extent, diversification. These securities are also held in a segregated account. Nonetheless, this has been of concern to regulators. The European Securities and Markets Authority put out guidelines in 2012, noting collateral liquidity was a concern. The guidelines stipulated 70% of the collateral should consist of liquid, listed large caps. It also said overcollateralisation is necessary when the ETF index type and collateral are not significantly correlated such as when they are not from the same asset class. The fund owns these assets in the segregated account and has direct access to them, meaning in the event the swap counterparty defaults, the ETF provider should be able to liquidate the assets swiftly. Exposure to the counterparty is the difference between the net asset value of the ETF and the value of the substitute basket the swap markto-market. Under Ucits rules, counterparty exposure must not exceed 10% of the fund s NAV. This means the daily value of the substitute basket must be at least 90 % of the NAV, so if the counterparty fails, investors should at least get back 90% of the ETF value. The swap, which is marked-to-market daily, is reset whenever the counterparty exposure approaches the 10% limit. When this happens, the counterparty delivers extra securities to the fund s substitute basket

12 Simplified unfunded swap ETF structure: Funded: INVESTOR SWAP COUNTERPARTY The other type of swap arrangement is the funded model, which was born in Europe in The main difference is the ETF does not take investors cash to buy a substitute basket. Instead, the ETF hands over the cash in CASH EXCHANGE ETF SHARES INDEX RETURN CASH BASKET RETURN SUBSTITUTE BASKET exchange for the performance of the index and will get the principal repaid at a later date. SWAP ETF SHARES AUTHORISED PARTICIPANT SWAP ETF CASH Source: The counterparty then posts collateral in a segregated account with a thirdparty custodian. It is important to note the account can be held in either the name of the fund or in the name of the counterparty, and pledged in favour of the fund. In the event of a counterparty default, the latter scenario could impact on the ability of the fund to liquidate the assets in a timely fashion. Regulations require that appropriate margins are applied to the collateral in case it changes in value due to market fluctuations and because of the risk that the fund does not actually directly hold the assets. As a result, these funds are usually over-collateralised, meaning the market value of the collateral posted by the swap counterparty is greater than the NAV of the ETF. Collateral is marked-to-market daily. It is also worth noting the rules applied to the collateral vary across jurisdictions, although they are all regulated by Ucits in Europe

13 Simplified funded swap ETF structure: Benefits of physical versus synthetic replication INVESTOR SWAP COUNTERPARTY Benefits of physical Benefits of synthetic ETF SHARES EXCHANGE CASH INDEX RETURN CASH CASH PRINCIPAL COLATERAL Holdings are transparent Limited counterparty risk Tighter tracking Can be lower in cost SWAP ETF SHARES AUTHORISED PARTICIPANT SWAP ETF CASH Source: Funded versus unfunded Negatives of physical Securities lending not that transparent Tracking is not always as tight Negatives of swap Counterparty risk to bank through swap (although this is mitigated by collateral) Holdings not always transparent Funded Collateral can have legal title given to the fund. This means collateral is in name of fund and should be easy to liquidate. Collateral can be pledged. This means the pledge has to be enforced. A time elapse could occur before liquidation goes ahead. Unfunded Fund has direct access to assets. Can liquidate collateral quickly. Trading and pricing Two of the main tenets underpinning ETFs are their liquidity and low costs. As an ETF trades like a stock, one indicator of liquidity is the traded volume. However, there is another arguably more important level of liquidity, stemming from the constituents underlying the fund and the ETF creation-redemption process. This special process means authorised participants can create additional 24 25

14 shares on demand, so supply is infinite, whereas supply of ordinary company shares, for example, is finite unless the company opts to issue more shares. ETF shares are created by the following process in the primary market: Conversely, when large investors want to sell a large chunk of shares in the primary market, APs can do the redemption process, where they exchange the shares for the underlying securities. It is this ETF creation and redemption process that keeps ETF supply and demand in balance. ETF PROVIDER This means the liquidity available to the ETF largely derives from this creation-redemption process, rather than the secondary market volumes of SECURITIES ETF SHARES IN-KIND TRANSFER ETF shares traded. Hence looking at the ETF share volumes is only seeing the tip of the liquidity iceberg. PRIMARY MARKET SECONDARY MARKET AUTHORISED PARTICIPANT This continuous creation and redemption process also keeps the ETF ETF SHARES price in line with its underlying NAV. The two do not always exactly match. For example, if a fund s market price is above its NAV, the ETF is trading BUYER AUTHORISED PARTICIPANT SELLER at a premium. This is positive for sellers, but negative for buyers if the fund is 101p, but the securities are worth 100p. The converse situation means the ETF is trading at a discount. Source: Morningstar Approved market makers called authorised participants (APs) do an in kind process, where they exchange baskets of the respective underlying securities, for a block of ETF shares, usually around 50,000, which are then available for trading in the secondary market. The basket of shares exchanged is weighted to match that of the respective index, for example the FTSE 100. ETF shares trade at a premium when an ETF s market price is above the value of its assets, or net asset value. Conversely, a discount is where the ETF s market price is below its NAV. These discrepancies arise when NAVs, which are calculated on the price of the underlying assets, become stale. This can happen when no recent trading has been done on the underlying securities, perhaps because they are illiquid or due to different trading hours, if they are international stocks. Premiums and discounts can be 26 27

15 larger during volatile times because NAVs fail to adjust as quickly. However, generally ETFs tend to match the value of their calculated NAV quite closely, due to the arbitrage mechanism used by market makers. This arbitrage opportunity allows market makers to gain a profit, while bringing the price and NAV back in line. For example, if the underlying securities are valued at 100p and the ETF s shares are 101p, market makers can deliver the securities to the ETF provider in return for ETF shares and then sell these more expensive shares. This means the market maker makes a profit. pence apart, investors take the midpoint to get an approximation of the NAV at that point. Performance and tracking error ETFs are meant to track an index, but the extent to which a fund achieves this can vary. It is important that an ETF does follow the index, because if it lags by a couple of percent, this seemingly cheap investment can end up being expensive. There are two main ways to measure this, which are sometimes used interchangeably even though they mean different things. The measure chosen largely depends on the investor s time horizon and investment objective. The process also reduces the size and frequency of premiums and discounts in the ETF shares. As they buy the shares it pushes the price up and as they sell the basket of stocks, it pushes the price down, and vice versa, bringing the two in line. Authorised participants will do this until a profitable arbitrage opportunity is squeezed and no longer exists, meaning the ETF will largely trade in tandem with the underlying stocks. As a result of any price discrepancies generally being small, long-term investors need not be concerned. Nonetheless, investors can still check whether the buying or selling price is in line with NAV. The bid and ask quotes offered on the market can be seen through most brokerages. If the bid and ask quotes are only a few Tracking difference: This refers to the total return difference between the fund and its index over a period of time. It shows the magnitude of under or outperformance of an ETF, which is not revealed in the other metric, tracking error. A small amount of tracking difference shows the ETF has performed well in matching the index over the time frame. Tracking difference tends to be negative; if an ETF perfectly tracks the index, it will underperform by its total expense ratio. Some ETFs can have a positive tracking difference and outperform, due to portfolio enhancing techniques, such as securities lending, for example

16 What causes tracking difference? It is caused by a range of factors, including tax of dividends, rebalancing and transaction costs, swap spreads, securities lending, among others. The main factor is the TER, which is also the most consistent contributor. Why does tracking difference matter? For investors looking to buy and hold an ETF over the long term, tracking difference is the more suitable measure, as they are more concerned on maximising returns and reducing costs. It is therefore important to check the tracking difference figure after fees have been taken out and look at tracking differences over a range of longer time periods. Tracking error: This is the volatility or standard deviation of the difference in returns between a fund and its index. It is viewed as a measure of risk: the higher the fund s tracking error, the more likely it is to out or underperform the index. Conversely, lower tracking error means the fund is more consistent in the amount it beats or lags the benchmark. markets or those indices with a vast number of securities. Why does tracking error matter? Short-term investors or managers looking to track an index precisely for hedging purposes or a specific mandate will generally focus on tracking error. This is more useful for an investor looking to trade frequently as part of tactical asset allocation. Other factors to consider: Revenue from securities lending could mean the ETF outperforms the benchmark. Although this increases tracking error, it does not increase the risk that the fund will underperform. 130 ETP Benchmark What causes tracking error? It is brought on by a similar range of factors to that affecting tracking difference, including differences in the securities in the fund and the index, transaction costs, tax treatment, securities lending and the type of fund replication. Tracking error tends to be higher for harder to access Day 1 Day 6 Day 11 Day 16 Day 21 Day 26 Day 31 Day 36 Source: ETF Securities, hypothetical example

17 Investors should also be aware of selecting the correct index to refer to, as there are different versions of the same type. For example, many equity indices are net total returns, comprising the returns plus dividends but minus withholding tax. Some ETFs track a price index, which does not include the dividend, or a gross total return benchmark which includes dividends and withholding tax. So selecting between tracking error and tracking difference as the most useful measure depends on the type of investor, the time horizon and investment objective. Nonetheless, both measures are worth considering. The cost question: Total Expense Ratio and total cost of ownership Custody and registration expenses Audit fees Factors affecting Total Cost of Ownership: Rebalancing costs Swap spreads Taxation Amount of cash held in the fund Securities lending Fund structure For example, the impact of structure: A physical ETF will incur rebalancing costs as the fund physically buys and sells the securities. The Total Expense Ratio (TER) is often misinterpreted as the full cost to bear for buying an ETF. However, in the past couple of years, the term total cost of ownership (TCO) has arisen to reflect more fully the overall cost of investing. The Total Expense Ratio generally includes: Management fee Administrative costs Conversely, a synthetic ETF will instead have a swap spread - a fee paid by the issuer to the bank. The spread will depend on the type of asset being tracked, the level of collateralisation and other issues negotiated between the ETF provider and counterparty. Other costs surrounding the investor s buying and selling must also be taken into account as part of the TCO: Bid/ask spread 32 33

18 Tax Brokerage fees ownership problems, difference in time zones when exchanges are open and expensive hedging. Bid/ask spread When investors buy an ETF on in the secondary market, there is a bid/ask spread, which is the cost involved in trading the securities, or the difference between the buying and selling price. Spreads tend to be quoted as a percentage of the security s market price. The bid/ask spread is found by subtracting the bid from the ask, divided by the share price and multiplied by 100. If the bid price for an ETF is 99p, for example, the offer is 101p, the spread is 101p minus 99p, divided by the share price and multiplied by 100 2%. The bid/ask price will have a bigger impact on the TCO for short-term investors, as even a 0.01% difference will have an impact on someone buying and selling in a couple of hours with a potentially smaller return than a longer-term investor. The more liquid the product, such as a FTSE 100 ETF, the tighter the spread tends to be, as there are more buyers and sellers. The opposite generally holds true, meaning an ETF tracking a less liquid market has higher spreads, due to a range of issues, such as foreign Other factors that can influence spreads include the number of market makers on the ETF, trading volume, the size of the fund, supply and demand, and the exchange on which the ETF is traded. Spreads on bond ETFs are usually wider than those for equity products, as fixed income markets operate over the counter, making the pricing less transparent. All these factors taken into account, the TER should be measured on a daily basis. An ETF s total return is the NAV minus the TER, while revenue from securities lending or other portfolio enhancing techniques is also accrued to the fund s NAV daily. For example, an ETF has a TER of 40 basis points (bps) and its tracking difference over a given year is a positive 50bps after TER. This is because the fund has outperformed the index due to securities lending. But the typical spread over this time period is 7.2 bps, meaning the TCO is 42.8bps, before extra costs, such as broker fees. It is also worth noting the tax situation can be used by the manager to provide additional revenue. For example, there might be differences between the tax of the index and that imposed upon the ETF portfolio, depending on the tax situation of the ETF s domicile and that of the underlying value

19 The who s who of securities lending Securities lending has come under increasing scrutiny in the past few years, shining a light on what was previously a largely hidden form of counterparty risk. After the intense clampdown on swap-based products by regulators, attention turned to physical ETFs and the risks involved in securities lending. The practice involves the ETF provider lending out the fund s securities to a third-party borrower, in return for collateral, a fee and payments equivalent to any dividends from the securities. Proponents say this additional income can be passed on to the fund, boost performance and ultimately cut the total cost of ownership. LENDERS (SUPPLY) BENEFICIAL OWNER ETF INTERMEDIARIES CUSTODIAN INVT. MANAGER LENDING AGENT SECURITIES FEES COLLATERAL PRINCIPAL-BASED TRANSACTION BORROWERS (DEMAND) BORROWERS BANKS MARKET MAKERS BROKER DEALERS END-USERS HEDGE FUNDS MUTUAL FUNDS TRADERS Sourse: Morningstar, ISLA However, there has been some criticism around the additional hidden risk imposed by this practice without sufficient reward, among certain providers. This is largely due to some providers lending out a large amount of the stocks at any one time, while keeping a significant proportion of the revenue, in some cases as much as 40% or 50%. Recent regulation from ESMA now requires Ucits products engaging in securities lending to return all revenues, net of operating costs, back to the fund. However, some asset managers have not changed their policies based on the view there is a lack of clarity over what constitutes cost and how much of the revenue can be used to cover the expense of engaging in securities lending. While State Street Global Advisors, for example, has an external custody agent that is paid by the revenue split, BlackRock has an in-house lending programme. Assessing a fund manager s lending programme is important as practices vary across companies. The main risk is that the borrower will default and cannot return the securities, while the value of liquidated collateral is not sufficient to repurchase the securities and recompense the investor. Securities lending practices tend to be over-collateralised, the value of which is marked to market daily, while securities are only lent once collateral is received. For example, BlackRock says its collateral ranges from 102.5% to 112% of the value of the loan, depending on the loan and collateral combination. Key points to consider are whether the lending is over-collateralised; the type of collateral; the amount of revenue given back to the fund; the amount lent out; and the nature of the borrower

20 The rise of smart beta The evolution of ETFs has reached a new phase, which is still taking root among investors. The rise of smart beta, otherwise dubbed alternative beta, addresses biases in market capitalisation weighted benchmarks to which investors do not want exposure. CLASSIC BETA Index replication FOCUSED BETA Niche asset classes FACTOR-BASED BETA Capturing: style bias, market cap bias, security behaviour ENHANCED BETA Index-plus, Structured products, Active ETFs GETTING SMARTER AT BUYING BETA BULK ALPHA Benchmarkconstrained, Active fund management PROVEN ALPHA GENERATORS Unconstrained alpha, Proprietary stock selection tools DIVERSIFYING ALPHA Private equity, Infrastructure, Commodities, Real estate, Managed futures, Volatility, Convertibles, Currency, Event-driven GETTING SMARTER AT BUYING ALPHA GOAL-FOCUSED ALPHA Liability-driven investment, Absolute Return mandates Source: Citywire pronounced when it comes to bonds. Many wealth managers have voiced concerns over buying these trackers, which provide most exposure to the least creditworthy firms with the most outstanding debt. Furthermore, many investors prefer active strategies or those where certain bond issues can be selected over others, to avoid issuer concentration. Smart beta products serve as a solution to such issues, by tracking indices based on alternative weighting methodologies, which avoid such biases. However, the rise of smart beta also coincides with a period of growing disillusionment with the active management industry. While many investors maintain a handful of actively managed funds can still add value, the bulk of these have not achieved a spectacular performance and in many cases have not even beaten the market. With fees of around 1.5%-2% tagged on, a lot of actively managed funds are losing assets to passives and are paving the way for the rise of alternatives, quasi-active exposure in a low-cost, liquid wrapper. Examples of smart beta strategies: Buying shares or bonds in proportion to their market value has thrown up criticism. Those investors seeking to avoid overvalued shares and those pursuing a value-based strategy might find a market-cap weighted index tracking the US simply gives unwanted exposure to the most expensive, overpriced stocks. The problem inherent in cap-weighted indices is arguably even more Equally-weighted indices give each security an equal weight. One of the more established strategies championed by index provider RAFI is fundamentally-weighted ETFs, which weights each company based on factors such as sales, dividends, assets or cashflow. Another method is GDP-weighted ETFs, where a country s aggregate 38 39

21 weight in the index is in proportion with its forecast GDP. Minimum variance strategies are an example of a volatility-focused method, based upon analysing stocks historical volatilities and their correlation with each other. From this analysis, an optimisation technique is used to determine the individual stock weighting to mitigate overall portfolio volatility. The process also uses constraints to ensure the portfolio is sufficiently diversified. There are also products that target specific strategies, such as income. The S&P Dividend Aristocrats range, for example, provides exposure to companies that have increased their dividend over a set number of years. Future of ETFs Looking to the US market might serve as a framework providing some insight as to what the future of the UK and European industry might look like. The older US market has a much higher uptake among retail investors. Although the retail distribution review only came into action at the start of the year, already more advisers who are no longer swayed by commission have more incentive to recommend these low-cost products to their retail clients. As education increases, the use of ETFs among retail is set to rise exponentially in the coming decade. Similarly to the US, where the regulator generally does not allow for ETFs that make substantial use of derivatives, the physical-based approach is still the most popular and is winning more favour with retail investors. More sophisticated investors are still opting for swap-based products to provide for efficient exposure to certain areas, such as the emerging markets, or for specific strategies, such as inverse products, yet more providers, such as Lyxor and Db-X trackers, are migrating some of their products to a physical structure. Other new types of ETP, such as active ETFs, are being launched in the UK, although whether they will gain significant traction remains to be seen. The active element particularly lends itself to asset classes or areas where there are disadvantages to capturing all securities in a market-cap weighted benchmark, or where a purely passive approach might not be as efficient from a risk-reward perspective. The active element means a specialist manager can select the bond issues, which can enhance yield and avoid those most indebted companies or countries. When active ETFs first emerged in the UK a few years ago, detractors pointed to the lack of transparency over holdings and the higher costs due to the active management. However, while the cost may remain elevated above passive ETPs, the transparency has improved with the main providers publishing holdings daily

22 Exchange-traded Funds CPD Programme You wouldn t buy a high-performance sports car that almost handled well. Or a Swiss watch that sort of kept time. After all, when you buy certain things you expect them to be precise. Shouldn t investments be one of them? At State Street, we think they should be. That s why we created SPDR exchange traded funds (ETFs), a family of physically backed ETFs that lets you precisely match your investments to your investment strategy. Whatever the market segment, you get exactly what s on the label. Nothing more. Nothing less. Dedication to Excellence State Street created the first ETF the SPDR S&P 500 * 20 years ago. Since then, each new member of the SPDR ETF family has been built to reflect our intimate knowledge of the ETF market. SPONSORED STATEMENT The SPDR Family of Exchange Traded Funds innovations in the last 20 years, starting with the SPDR S&P 500 ETF. As an innovator in the marketplace, SPDR ETFs have helped to deliver thoughtful products to investors and collaborate with other industry leaders to expand the set of products available. Physically Backed We believe ETFs are about finding simple solutions to precisely meet investors needs. All of our ETFs are physically backed, providing a simple, transparent way to access each market segment. Core SPDR ETFs are benchmarked to an array of respected market indices. While the SPDR S&P 500 is one of the largest and most actively traded securities in the world, we offer equity ETFs of every size. TEST To receive your full hour of structured CPD, go to and take the test online. If you get 70% or above, we will send you confirmation that you have successfully completed the module. Engineered for Precision To craft the best products, SPDR ETFs aim to turn complex problems into simple solutions in order to match your investment needs as precisely as possible. Whether you seek broad market access or targeted exposure, we carefully select the most appropriate indices that give you precisely what you expect from each SPDR ETF. Institutional Quality SPDR ETFs are designed to meet the high standards of professional investors, including the pensions and endowments of the world s largest corporations and foundations. ETF Pioneer SPDR ETFs pioneered many of the industry s Sector With sector ETFs, you get targeted, diversified access to specific sectors without the risk level of single stocks. Sector ETFs can also be valuable for tactical weightings and hedging portfolio risk. Fixed Income With our fixed income ETFs, you get the benefits of diversification and potential income in one precise package. Just one ETF provides the performance of an entire bond portfolio so you won t have to constantly rebalance your holdings as bonds mature. Emerging Markets We offer an array of emerging market equity and fixed income SPDR ETFs so you can get diversified, liquid exposure to even the most difficult-to-reach markets. *SPDR S&P 500 ETF (SPY US) is not registered for sale in Europe. SPDR ETFs is the exchange traded fund ( ETF ) platform of State Street Global Advisors and is comprised of funds that have been authorised by European regulatory authorities as open-ended UCITS investment companies. ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. The value of the investment can go down as well as up and the return upon the investment will therefore be variable. Changes in exchange rates may have an adverse effect on the value, price or income of an investment. Further, there is no guarantee an ETF will achieve its investment objective. SPDR ETFs may not be available or suitable for you. This advertisement does not constitute investment advice or an offer or solicitation to purchase shares of SPDR ETFs and has been issued by State Street Global Advisors ( SSgA ). SPDR ETFs may be offered and sold only in those jurisdictions where authorised, in compliance with applicable regulations. You should obtain and read a prospectus and Key Investor Information Documents (KIIDs) relating to the SPDR ETFs prior to investing. Further information and the prospectus/kiids describing the characteristics, costs and risks of SPDR ETFs are available for residents of countries where SPDR ETFs are authorised for sale, at and from your local SSgA office. SPDR is a registered trademark of Standard & Poor s Financial Services LLC ( S&P ) and has been licensed for use by State Street Corporation. No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by S&P or its affiliates, and S&P and its affiliates make no representation, warranty or condition regarding the advisability of buying, selling or holding units/shares in such products State Street Corporation All rights reserved. IBGE

23 Exchange-traded Funds Notes 44

24 Exchange-traded Funds